What to Consider Before Using a Personal Loan as a Down Payment

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When it comes to buying a home, one of the biggest obstacles you might face is coming up with a down payment.

In an Apartment List study, millennials in over half of the metropolitan areas surveyed reported that it would take at least 10 years to save 20% for a down payment.

If you don’t have a large enough down payment, you might start researching alternatives, such as using loans or gifts. But can you use a personal loan for a home down payment? Here’s what you need to know.

Can you use a personal loan for a home down payment?

It seems like the perfect plan: Calculate how much you need for a down payment and apply for a personal loan for that amount. But there are some drawbacks and considerations to keep in mind.

Not all personal loan lenders prohibit using a personal loan for a down payment, but most mortgage underwriters do — and here’s why.

Personal loans are a riskier form of debt

When you take out a mortgage, your new home’s value acts as a form of collateral. If you fall behind on your payments or default on your mortgage, the lender can seize your house and sell it to recoup the money you owe.

Personal loans typically don’t have those same protections. They’re unsecured debt, meaning you don’t have to put up collateral. If you default on the loan, your credit can be ruined, but the lender can’t seize any of your assets.

Because there’s more risk to the lender with personal loans, mortgage underwriters usually won’t approve applications that use loans for down payments.

Loans raise your debt-to-income ratio

When you take out a personal loan, you raise your debt-to-income ratio, which is the amount of debt you have compared to how much money you bring in each month. The worse the ratio, the less likely a mortgage lender is to issue you a loan.

Lenders want to know you can handle the payments

Mortgage lenders are willing to do the heavy lifting for you. They’ll provide you with the money you need to buy a home.

But they ask for a down payment because they want to know that you have skin in the game and are invested in the process. Saving a down payment is a sign of good faith that you plan on making your loan payments and can afford them.

If you need to borrow money for the down payment, that can be a major red flag to mortgage lenders.

You’ll face high levels of debt

If you do manage to get approved for a mortgage using a personal loan for a down payment, you’re making a risky mistake.

Personal loans can have high interest rates — some as high as 199.00% — and shorter repayment terms than a mortgage. That difference can lead to high monthly payments on top of your regular mortgage payment.

Between high-interest personal loans and a home loan, your debt might be too high for your budget, increasing your risk of falling behind.

3 types of home loans with low down payment requirements

Traditionally, potential homebuyers are advised to save 20% of a house’s purchase price as a down payment. Although that’s a good rule of thumb, it’s not realistic for everyone, especially for some first-time homebuyers.

There are mortgage programs that have reduced down payment requirements that can make buying a home more affordable.

1. Federal Housing Administration loan

With a Federal Housing Administration (FHA) loan, you can put down as little as 3.5% as a down payment. The FHA backs the loan, lessening the risk to lenders, making them more willing to issue loans to buyers, including those with little money saved or less-than-perfect credit.

For more information, visit the U.S. Department of Housing and Urban Development website.

2. Veterans Affairs loan

If you served in the military, you might not need any down payment at all. A loan from the U.S. Department of Veterans Affairs (VA) can cover the total of your home’s purchase price, eliminating the need to save money for a down payment or private mortgage insurance.

Visit the VA home loans site for details.

3. HomeReady mortgage program

With Fannie Mae’s HomeReady mortgage program, you could buy a home with a down payment of just 3%. On a $200,000 home, that means you’d need to save just $6,000 to buy a house.

To qualify for the program, you need to have a credit score of at least 620 and complete a homeownership education course. For more information, visit the HomeReady mortgage program website.

Buying a home

Can you use a personal loan for a home down payment? Maybe, but thanks to strict underwriting processes and high interest rates, it can be an expensive and risky decision. Instead, explore your other home loan options that require a low down payment.

If you’re looking for a home loan, check out the best mortgage lenders for first-time buyers.

Our team at Student Loan Hero works hard to find and recommend products and services that we believe are of high quality and will make a positive impact in your life. We sometimes earn a sales commission or advertising fee when recommending various products and services to you. Similar to when you are being sold any product or service, be sure to read the fine print understand what you are buying, and consult a licensed professional if you have any concerns. Student Loan Hero is not a lender or investment advisor. We are not involved in the loan approval or investment process, nor do we make credit or investment related decisions. The rates and terms listed on our website are estimates and are subject to change at any time. Please do your homework and let us know if you have any questions or concerns.

Published in Loans, Personal Finance